Investment Allocation and Performance in Venture Capital Scott Hsu - PowerPoint PPT Presentation

Investment Allocation and Performance in Venture Capital Scott Hsu Vikram Nanda Qinghai Wang U of Arkansas U of Texas Dallas U of Central Florida

The Unique Structure of VC Funds § VC (PE) funds have a typical 10-year life span – VC firms need to keep raising new funds. Kleiner, Perkins, Caufield & Byers Fund Vintage Year Committed capital ($M) NET IRR II 1980 65 50.6% III 1982 150 10.2% IV 1986 150 11.0% V 1989 150 35.7% VI 1992 173 39.2% VII 1994 225 121.7% VIII 1996 299 286.6% IX 1999 550 -23.3% X 2000 625 -17.5% XI 2004 400 XII 2006 600 XIII 2008 700 XIV 2010 625 XV 2012 525 XVI 2014 450 XVII 2016 400

The Unique Structure of VC Funds (Cont.) § VCs start the next fund while the current fund is still active. § Our research question: If there is a “next Google” in between two funds, would the VC place it to the current fund or the next one? § Why? § Implications for VC fund structure & performance (persistence)?

Does VC fund structure (or fundraising motive) affect investment decisions? § Our story: Can affect VC investment and/or investment allocation decisions. § Within a VC fund. § Across VC funds when two funds overlap in time. § Such decisions can then affect VC fund performance, and performance persistence. § Such behavior has implications for VC-Investor relation, as well as the VC-entrepreneur relation.

How does the VC fund structure (or the fundraising motive) affect investment decisions? § We have a stylized model. § Find existence of an equilibrium in which raising capital for the next fund is affected by the early success of current fund. § In such an equilibrium, VCs allocate higher quality projects in the early investment period. § Intuition – VC’s have limited time/ability and choose where to put in most effort. Gives rise to a coordination equilibrium in which VCs allocate effort to projects in the new (or young) fund – and learning about their ability primarily occurs depending on success or failure in new fund. § Possibility if multiplicity of equilibria – but less likely because the VC benefits from better contract in the new fund that is where he is expected to devote his energies.

Predictions from the model § Higher probability of success in early investments. § For two sequential funds, during concurrent investment period, better quality projects are allocated to the new fund instead of the current fund. § Performance of early investments is more informative across VC funds of the same VC firm.

Data and Sample § Information on VC firms, VC funds, and VC investments: Venture Xpert. § Focus on VC fund investments by lead VCs. § VCs that make investment (allocation) decisions. § 2,617 firms, 4,578 funds, and 17,154 companies from 1975 to 2010. § Measuring investment outcomes using successful exit: IPOs and IPOs/M&As. § Used and accepted in academic research.

VC Portfolio Company Exits (univariate) – as Lead VC 8

Within fund performance: early investments in a fund perform better (Table 3) (1) (2) (3) Dep. Var: =1 if IPO =1 if the First Investment 0.2291*** (2.653) Investment Sequence No. -0.6262*** (-5.082) =1 if First-year Investment 0.2512*** (3.221) (4) (5) (6) Dep. Var: =1 if IPO or M&A =1 if the First Investment 0.2358*** (4.113) Investment Sequence No. -0.5826*** (-7.211) =1 if First-year Investment 0.2763*** (4.960) Controls: Fund sequence, fund size, seed/early stage, No. of IPOs, Ind. M/B ratio, bubble period dummy, VC firm fixed effects.

Why do early investments in a fund perform better? § (Natural) Decline in the quality of the projects available within the fund. § Could be partly driven by the investment allocation across the funds of the same VC, as suggested by the model. § How to test the investment allocation story? § Use the “paired” VC fund sample – two funds with overlapping investment period.

The “paired” VC fund sample – some definitions — Concurrent investment period: One-year period after the start of the second fund’s first investment. — First fund: early investments (pre-concurrent period); later investments (concurrent period) — Second fund: early investments (concurrent period); later investments (post-concurrent period)

Exit rate of the “paired funds” (Table 4) Second Fund First Fund Prior to First Fund during during Concurrent Concurrent Period Concurrent Period Period IPO Rate 10.11% 3.51% 9.11% IPO and 31.48% 13.71% 36. 06% M&A Rate

Investment outcome of the paired funds during concurrent period (Table 5) Dep. Var. IPO IPO+M&As Ln(Financing rounds) (2) (4) (6) 0.230* 0.315*** 0.150*** =1 if Investment from Second Fund (1.88) (4.35) (5.00) — Logit & Linear Probability Models (above are OLS results) — Controls: VC FE, Fund sequence, size, size-squared, early stage/seed fund, no. of IPOs in prior to fund’s vintage year, industry M/B, seed/early-stage company, dummy for for 1995- 2000. — The results are more pronounced if (1) the first fund has successful early investments, and (2) the lead VC is more reputable (Table 6).

Performance persistence (fund-level; Table 7) § Use IPO or IPO/M&A dummy as performance predictor. § Performance persistence across two funds (Models 1 and 2). § No performance persistence within the (first) fund (Models 3 and 4). Second Fund (Total First Fund Later Investments) Investments IPO IPO/M&A IPO IPO/M&A 0.479*** IPO in First Fund Investments (3.33) 0.331*** IPO/MA in First Fund Investments (2.65) 0.066 IPO in First Fund Early Investments (0.24) -0.247 IPO/M&A in First Fund Early Investments (-1.53)

Performance persistence (fund-level; Table 8) § First fund early investment success predict second fund early investment success (Models 1 and 2). § First fund early investment success predict second fund overall investment success (Models 3 to 6). (1) (2) (3) (4) (5) (6) Second Fund Early Second Fund Overall Investments Investments Dep. Var. IPO IPO/MA IPO IPO/MA IPO IPO/MA IPO First Fund Early Inv. 0.433*** 0.515*** 0.514*** (2.81) (3.45) (3.45) IPO/MA First Fund Early 0.248** 0.260** 0.259** Inv. (2.1) (2.17) (2.16) IPO First Fund Late Inv. 0.062 (0.15) IPO/MA Fist Fund Late Inv. 0.324 (1.26)

Investment Outcome and Fundraising (Table 9) § Early investment success leads to more fundraising. § The results are insignificant for more experienced VCs. § Provides motives for investment allocation across VC funds. (1) (2) (3) (4) (5) (6) Dep. Var: Probability of raising next fund within the first 5 years All VCs High Experience VCs Low Experience VCs 0.371*** 0.271 0.515*** =1 if first investment (2.75) (1.37) (2.73) success 0.488*** 0.126 0.685*** =1 if first year investment (3.16) (0.53) (3.16) success

Conclusion § VC fund structure (or the fund raising incentive) affects VC investment/ investment allocation decisions. § We provide a stylized model for the rationales. § We find evidence of investment allocation. § Investment allocation has impacts on observed investment outcome and VC fund performance persistence.